You may not have been sitting on the edge of your chair while the recent drama at JPMorgan Chase played out, but you should have been. The bank has found itself fighting a derivatives culture which has been sabotaging global economies for years.
Bloomberg explains the issues:
Botched trades by a JPMorgan Chase & Co. (JPM) unit that Jamie Dimon had pushed to boost profit were masked by weak internal controls and may ultimately saddle the bank with a $7.5 billion loss.
JPMorgan’s chief investment office has lost $5.8 billion on the trades so far, and that figure may climb by $1.7 billion in a worst-case scenario, Dimon, the bank’s chairman and chief executive officer, said yesterday. Net income fell 9 percent to $4.96 billion in the second quarter, the bank said. It restated first-quarter results to reduce profit by $459 million after a review of the unit found employees may have hid souring bets.
Sound familiar? Dimon, to his credit, has taken swift, and commendably/appropriately brutal, action to deal with a product which was originally his baby. He hasn’t dodged the bullet, but taken it and done something visible about it. Managers are being removed and having millions of dollars of their pay clawed back, and the London CIO unit has been put into suspended animation. The loss was revealed, and no fairy tales have been put out trying to sugar the situation. JPM stock actually went up on the basis of the “relief factor” that things weren’t worse.
The derivatives market suffers from being a very fluid moving target when it comes to valuations. Trade in these financial products happens at blinding speeds and in huge volumes, often enough to actually affect the whole market. Values move, quality of products varies, and trader behaviour, to put it mildly, covers a spectrum from “pleasantly vague” through to downright dishonesty and systemic fraud.
When you’re talking about large numbers of billions of dollars, “vague” isn’t much of an asset. Nor are the dud derivatives. They’re junk. Finding the problem is only the start of the process. Shoring up the damage and removing the fluff from valuations is the next, thankless, task.
This issue, so far as is known not in the same catastrophic league as the mortgage securities disaster, fortunately for all involved. JPM isn’t about to turn into another Lehmann Bros. That said, the real problems are far more insidious than that, very hard to define, and that ambiguity is what’s likely to spook financial markets. Doubt is an investment-killer.
The derivatives culture stinks. If you’ve read Barbarians at the Gates, you’ll remember the prophecy that the investment culture could turn into an ethics-free environment, selling any old crap and ripping off investors wholesale, while making big money at the same time.
The origin of this culture was the original junk bonds culture of the 1980s. Since then, the number of ways of borrowing, turning borrowing into a paying asset and trashing investments has spiralled into literally thousands of derivatives.
(a) You borrow X amount of money against a valued asset.
(b) You then sell the debt, get your money back and to hell with the people that buy the derivatives.
Sounds healthy, doesn’t it?
The market has learned, expensively, how to manage these things. When the mortgage securities crisis hit, the Exchange Traded Funds holding mortgage securities were absolutely hammered. There was a deep vertical drop in their prices, by association. The same ETFs went up vertically a couple of days later when it was realized that they were holding very good, high value assets, not the crap that went bust.
Not all derivatives are turkeys. Some are good investments. That said, in an environment when anybody can put any damn number on a balance sheet and have a good chance of that number being believed, it’s hardly a safe place to invest. The markets do not like this situation, in terms of keeping their own skins intact.
The irony here is that the JPM saga has exposed yet another, absolutely deadly weakness which affects the banks themselves.
The New York Times JPMorgan Chase disclosed on Friday that losses on its botched credit bet could climb to more than $7 billion and that the bank’s traders may have intentionally tried to obscure the full extent of the red ink on the disastrous trades.
Mounting concerns about valuing the trades led the company to announce that its earnings for the first quarter were no longer reliable and would be restated. Federal regulators, who were already examining the trades, are now looking at whether employees of the nation’s biggest bank by assets intended to defraud investors, according to people with knowledge of the matter.
The “intent to defraud investors” is a perfectly valid point, but there’s another angle, which is where “too damn cute” enters into the headline for this article:
1. It also means that the traders are able to disguise their moves to the banks. That’s no great surprise if you consider the size of the losses, until you realize that it also represents a systemic failure of potentially massive proportions:
2. If they’re prepared to hide $X billion in losses, what’s to stop them “advising” their colleagues how to do that with other products and high value assets?
3. Finding these things is not necessarily easy. A lot of valuations are signed off on up the chain and enter the audit trail every second.
4. The banks, inevitably, have to do the work after the damage is done. Any regulator will tell you that “regulation” is really about creating a rule book so people know what’s going on, if you’re expecting your regulations to work at all.
5. The banks are being treated like idiots. Obviously, people know how to manipulate their internal operations well enough to achieve multi-billion dollar crash and burn scenarios and keep them running for years. Apparently the guys hiding information were fairly sure they could get away with it.
The current investment culture is too damn cute. It’s an image. It looks like Barbie and acts like Freddie Krueger on a routine basis. The best business people are often baffled by this dichotomy, and try to see through the image- To yet another false image of dedicated sales work, based on nothing but hot air and spin, and obscuring the hard dollar issues in a haze of “team player” BS which is as worthless as the balance sheets usually turn out to be.
Dimon’s the guy carrying the mop and bucket, and seems to have thoughtfully brought an axe with him to deal with the turkeys, beyond the usual conversations about cranberries and candied yams. How he gets Barbie out of this will be interesting to see. It’s also quite likely to be a precedent for a long-overdue session of head-kicking and enforcement of best practice in the banks.
He’ll be a saint if he gets the mix right, and another Ken Lay by inference, if he doesn’t. The sector as a whole and the business media in particular need to watch this carefully, because this could be the very big straw for the arthritic camel that everyone’s been dreading.
This opinion article was written by an independent writer. The opinions and views expressed herein are those of the author and are not necessarily intended to reflect those of DigitalJournal.com